Coal Feeding The Hunger For Power

Overweight on the sector
We initiate coverage on the coal sector with a positive view reinforced by the strong earnings growth momentum, exciting demand-supply dynamics and Indonesia’s strategic position in the global seaborne coal market. The coal companies under our coverage are projected to deliver earnings growth of 67% – 46% in the 2011-2012 period, comfortably outperforming the overall market’s earnings growth of 8% – 18% over the same period. Having said that, the sector PER at 15.6x 2011f earnings which is higher compared to the JCI PER of 14.9x 2011 earnings is justified given the stronger earnings growth, we believe.

Hot coal prices fuelled by fundamentals
From 2004 to 2009, Indonesia’s coal production grew at a CAGR of 13.3%, with 75%-80% of the total volume exported. This strengthens Indonesia’s position as one of the major suppliers of seaborne thermal coal as well as reflects rising demand from the global market. Indonesia’s strategic demographic location facilitates the efficient shipment of coal, which enables it to offer end-users more competitive pricing, especially in the Asian region.

Demand set to ignite
Domestic coal demand is set to surge as more local coal-fired power plants come onstream. Adding to this equation is demand from coal-hungry countries like India and China, which together create supply-demand dynamics that are favourable to coal producers. This scenario bodes well for coal price, and will in turn boost the profitability of coal miners.

Valuations and top picks
In our coal coverage universe, our top picks are HRUM and KKGI while ADRO is the industry benchmark due to its large market cap as well as sizeable coal production. We also reinstate our coverage on PTBA and ITMG with a NEUTRAL call as both companies’ growth profile and profit margins are relatively more modest than their peers’.

HRUM is currently trading at 15.3x FY11f earnings, with a 14% upside potential while KKGI is valued at 10.4x FY11f earnings, providing a 17% price upside. For the record, the industry is currently trading at 15.6x FY11f earnings while the overall Indonesia index is valued at 14.9x FY11f earnings.

Key risks
The key risks to the Indonesian coal industry are: i) a significant correction in energy prices, ii) extreme weather conditions, iii) regulatory changes; and iv) slower than expected global economic growth.

Investment Thesis

We are initiating coverage on the Indonesian Coal sector with an Overweight rating and positive stance on two companies – Harum Energy (HRUM) and Resource Alam Indonesia (KKGI). The growth profile of these two companies is intriguing as they are well positioned to capitalize on the robust demand as well as high coal price. The coal sector underperformed the broader market (JCI) in 2011 ytd by 1.1%, which provides huge potential for a turnaround in 2011 on the back of better coal prices.

The sector is trading at an aggregate 2011-2012F PER of 15.6x-12.5x vs the overall market’s 14.9x-12.4x. We see this sector registering an earnings CAGR of 60.3% from 2010-2012f, driven by higher sales volume and average sales prices (ASP).

On the back of coal prices of above USD120/tonne YTD, we are revising our coal price assumption for 2011 to USD125/tonne (+14%) and to USD130/tonne (+13%) for 2012, with a long term price assumption of USD90/tonne. Given the above-mentioned scenario, we are optimistic that Indonesia’s coal companies would generate robust earnings growth, with the ones chalking up higher volume growth emerging as the absolute winners as new tonnage will be benchmarked against current coal prices.

The broad rationale for our Overweight call on the coal sector is as follows:

Seaborne coal demand will accelerate in upcoming years
Based on AME’s report, coal imports from China and India experienced a CAGR of 27% while that for the rest of the world stood at 3% from 2001-2011. miningweekly.com, quoting another report from Wood Mackenzie, said that by 2011, China would overtake Japan as the world’s largest thermal coal importer. And by 2019, demand for imported coal thermal coal from India will outpace China’s.

Being one of the fastest growing economies in the world, India is hungry for coal owing to demand from rapid development of its power plants, cement and fertilizer industries. Coal accounts for half of India’s total energy consumption. Indonesian Coal Mining Association (APBI) estimates that India will surpass Japan as the biggest buyer of Indonesian coal in 2011, with a total projected import of 70m tonnes compared to 40m tonnes in 2010.

Meanwhile, India’s coal consumption was projected at 661m tonnes for 2010, which will increase to 705m tonnes for 2011 (+6.6%) and further to 754m tonnes (+6.9%). Despite having 14% of the world’s recoverable coal reserves, India has been unable to meet its domestic demand and thus needs to import to cover the shortfall.

Robust growth from Indonesia’s domestic demand
Indonesia is currently developing more power plants to ramp up electricity supply as its economy continues to expand. The Indonesia government is emphasizing on increasing the use of coal as source of energy owing to its relatively abundant reserves and the lower cost compared to fossil fuel. For starters, the government’s first phase of building 10,000MW coal fired power plants is already underway, with an expected completion rate of more than 60% by end-2011. Currently Indonesia’s electricity ratio is still at c. 67%. The State Electricity Company (PLN) aims to increase this ratio to 90% that by 2018.

PLN’s latest projection revealed that its coal requirements for the coming years will continue to accelerate at a CAGR of 24% from the 2010-2014 period. This, combined with the impact of robust global demand as well as rising domestic demand, will create favorable supply-demand dynamics for coal producers.

Indonesia positioned for exciting coal market dynamics
Indonesia was a key global player in terms of coal supply for the seaborne market. This is due to its strategic demographic location compared to its peers Australia and South Africa. Indonesia offers more efficient cost to the fast growing coal importer markets in China and India in terms of lower production and freights cost compared with Australia and South Africa producers.

Firing up production

For the 2005-2009 period, Indonesia’s coal production was on an upward trend, chalking up a CAGR of 13.3%. With some 75%-80% of total production allocated to the export market, this solidifies Indonesia’s role as one of the major coal suppliers in the global market. Going forward, the production from Indonesia will continue to accelerate at an expected production volume of 321m tonnes by 2015, rising further to 405mn tonnes by 2020 (according to Indonesia’s Coal Book 2010/11).

With domestic demand on the rise and potentially taking up a larger portion of Indonesia’s coal production, we believe that global supply will be impacted, but this is a positive driver for coal prices going forward. Therefore, we project a coal price of USD125/tonne for 2011 and USD130/tonne for 2012 respectively. All of the coal companies within our coverage universe are projected to deliver stronger volume growth in the coming years, with KKGI and HRUM enjoying the highest growth.

Valuation and top picks
Our top pick for the coal sector is HRUM, for which we have a Buy rating with a TP of IDR10,450 , implying a 14% upside potential. The company’s key catalysts are its strong volume growth, better ASPs as well as robust balance sheet. HRUM is trading at a 2011F PER of 15.3x vs the industry’s 15.6x. The second is KKGI, a small cap coal company with an intriguing growth profile. While we understand that the company’s small market cap as well as thin trading liquidity might be a concern, its compelling multiples combined with strong earnings growth are hard to resist. KKGI is trading at only 10.4x FY11f earnings, which is very undemanding, and which provides an attractive upside potential of 17% at our TP of IDR5,150.

Risks to our call
The key risks to the Indonesian coal industry are: i) a significant correction in energy prices, ii) extreme weather conditions, iii) regulatory changes, and iv) slower than expected global economic growth.